One of the first decisions a business owner is faced with is what business entity they should choose for their company. For many businesses, the choice comes down to two options: a limited liability company (LLC) or S corporation. An S corporation is so named because it is taxed under Subchapter S of the Internal Revenue Code. These two business forms have some things in common, but the differences between them determine which choice is to your business’s best advantage.
Let’s first discuss how LLCs and S corporations are alike. Although only LLCs have “limited liability” in the name, both business forms offer limited liability protection to the owner of a business. This protection is why most people form a business entity rather than owning the business in their own name as a sole proprietor. Creditors of a business can reach the sole proprietor’s assets, whether or not those assets are connected to the business. S corporations and LLCs are separate entities from their owners, whose only liability for the company’s debt is limited to their investment in the LLC or S corporation.
Another advantage shared by LLCs and S corporations is “pass-through taxation.” Income and losses are not taxed to the company, but pass through to its owners to be reported on their personal income tax returns. (In contrast, income of C corporations is taxed twice: at the corporate level and again on dividends paid to shareholders.) While both LLCs and S corporations feature pass-through taxation, the overall tax rules governing the two types of entities are quite different.
If you want limited liability protection and pass-through taxation for your business, either an LLC or an S corporation is probably the right option for you. But how do you choose between them?
One of the biggest advantages of an LLC for a business owner is flexibility. Corporations, including S corporations, are subject to more rigid rules regarding their management. An S corporation is governed by a board of directors. It must hold directors’ meetings and an annual shareholders’ meeting, with specific rules about how and when notice must be given of the meetings and what minutes of the meeting must contain. An LLC does not have such strict requirements, and the company can be managed by its members (or, if preferred, by managers).
An LLC also enjoys benefits such as pass-through taxation by default. In contrast, an S corporation needs to adhere to certain IRS regulations in order to claim this benefit. If, at any time, it runs afoul of those regulations, it could lose pass-through taxation status and be subject to the double taxation of a C corporation.
In order to elect S corporation status, a business must:
If any of those restrictions would be difficult to meet, an LLC would be a better option than an S corporation.
While an LLC is automatically granted pass-through taxation status, it can still make an election that allows it to be taxed as an S corporation or C corporation. An LLC’s owners should make such an election only after careful consultation with the company’s tax advisor. Be aware that an LLC that elects S corporation tax treatment is bound by the same restrictions as an S corporation.
While LLCs generally offer greater flexibility, there are still situations in which an S corporation is the more desirable option. For good or ill, a business operating as a corporation may have greater prestige than one operating as an LLC. That can translate into an easier time obtaining outside funding from investors and financial institutions, who may feel more comfortable investing in a corporation.
S corporations may have tax advantages over an LLC, too. Employee owners of an S corporation may receive both salary and dividends; this can reduce the corporation’s taxes. (Be warned that the IRS requires S corporation salaries to be “reasonable,” so owners shouldn’t play fast and loose with salary amounts.) LLC owners, on the other hand, are required to pay self-employment taxes, which can increase their tax burden.
If you think you might ever want to convert your business to a C corporation (such as in order to go public), it is much easier to do so if the business was an S corporation than if it was an LLC. An S corporation need only file a single form with the IRS to convert to a C corporation. To convert an LLC to a C corporation involves much more effort and, of course, expense.
Choosing a business entity is not something you should do lightly. If you have questions about whether an LLC or S corporation is better for your business, we invite you to contact Gudorf Law Group to schedule a consultation.